These days, more Accounting pros are caught in a business dilemma:

You’re under orders to save money wherever you can. At the same time, you’re supposed to hold off on making payments until the last minute to bolster cash flow.

So how do you handle early-payment discounts?

To figure out if forking over the money sooner is worth the discount you’d get, you have to figure out the effective annual percentage rate. Let’s look at an example:

Your vendor offers you a discount of 2% if you pay within 10 days  (2/10 net 30).  In essence, you’d save $10 on a $500 order, if you pay 20 days earlier than usual.  

To figure out the effective annual interest rate, use the following formula, where 360 = days in the fiscal year, and N = the number of days between the discount date and the final payment deadline:

Discounted amount /Discounted price   X  360/N  = Effective annual interest rate

So, in this case $10/$490 X 360/20 = 36.7%.

Rather than calculate the effective interest rate for each transaction, you may want to get upper management to set a threshold for when it’s worth taking the discount and when it’s not. For example, you might make it a policy to take the discount whenever the interest rate is above 20% or would save more than $500.

Bear in mind, even slight changes in the terms can have a big effect on how much (or how little) your company stands to save by paying early. For reference, here’s a list of effective annual interest rates for some common discount terms, as calculated by the American Institute of Professional Bookkeepers:

• 1/10 net 30 = 18.2%
• 1/10 net 45 = 10.4%
• 1/10 net 60 = 7.3%
• 2/10 net 30 = 36.7%
• 2/10 net 60 = 14.7%
• 2/20 net 90 = 10.5%
• 3/10 net 30 = 55.7%
• 3/10 net 60 = 22.3%
• 3/20 net 90 = 15.9%

Another point to consider when you’re debating whether or not to take an early-payment discount is less easily quantified. Some vendors offer other perks to early payers, such as faster shipping, special promotional offers, etc. For vendors you use frequently, those perks may make early payments even more practical.

What’s the policy at your company? Do you take every discount you can, stretch payments as long as you can — or take it on a case by case basis? Let us know in the comments.

Tags: A/P, A/P resource, Cutting costs, Discounts